U.S. yield curves flattens but recession seen distant

NEW YORK (Reuters) - The yield gap between shorter-dated and longer-dated bonds is shrinking in the United States, raising concerns among traders over when the second-longest U.S. economic expansion in modern history will come to an end.

The ultimate fear is that shorter-dated yields will rise above longer-dated ones, a market phenomenon known as a yield curve inversion and one that has preceded the past three recessions.

Top bond managers and strategists at the Reuters Global Investment 2018 Outlook Summit said this week that while they were mindful the yield curve touched its flattest level in a decade last week, they saw a remote chance of a recession as the jobs market had improved.

“If we were to see a flat to an inverted yield curve, that would be a cause for equity pullback,” said Larry Fink, who runs BlackRock Inc, the world’s largest asset management company.

On Tuesday, the yield spread between two-year and 10-year Treasury notes was 69.00 basis points after hitting 65.90 basis points on Thursday, which was last seen in November 2007, Reuters data showed.

The yield curve flattens for a protracted period when the Fed tightens monetary policy. Investors often respond by reducing their holding of local shorter-dated debt and raising their stakes in longer-dated issues.

“That in itself is not a good indicator” of a pending recession, said Joachim Fels, Pimco’s global economic advisor and a managing director. “We are still far away from inversion.”

The U.S. yield curve has been flattening since the end of 2013 when the Federal Reserve announced the tapering of its monthly bond purchases that grew its balance sheet to $4.5 trillion.

Nearly four years ago, the two-to-10-year part of the yield curve stood at 2.67 percentage points.

Investment in curve-flattening trades has grown since the Fed started its rate-hike campaign at the end of December 2015 and inflation has remained sluggish.

CURVE FLATTENING ELSEWHERE

Yield curves in bond markets outside the United States have been flattening too.

Other major central banks have raised interest rates or considered scaling back bond purchases due to their economies improving.

(For a graphic on 'Yield Curves Among Major Economies' click reut.rs/2zp9qPj)

For example, the yield gap between two-year and 10-year UK gilts contracted to 75.4 basis points last week, which was the flattest level in about 13 months following the Bank of England’s rate hike earlier this month.

British interest rate swaps imply that traders expect the BOE will increase rates only twice over the next three years.

Back on this side of the Atlantic, the futures market signaled traders have fully priced in a quarter-point hike in December and are leaning towards two rate increases in 2018.

More rate hikes and low inflation would flatten the U.S. yield curve further, said Nick Gartside, JP Morgan Asset Management’s international chief investment officer for fixed income, currency and commodities.

It could “get really close to zero next year,” but that is unlikely a recession indicator, Gartside said.